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Dividends, payout ratios and their importance

Jun 19, 2009

In the previous article of this series, we had discussed about items that are found at the bottom of the profit and loss account - taxes, net profits and appropriation. In this article, we shall discuss about dividends and its impact on investors. There are two ways in which an investor can profit from his investment in stocks. One, through stock price appreciation, which we know can remain depressed for a long duration even if the fundamentals of the underlying company are strong enough. Another way to profit from an investment in a stock is through dividends.

Dividends, unlike stock prices, do not depend on the whims and the fancies of the investor community at large. If the business is performing well and generating cash in excess of what is required for growth, dividends are paid out irrespective of the stock price movement.

As mentioned in the earlier article, a company can do two things with the profits that it earns. It can either invest it back into the company (into reserves and surplus) and/or pay out the amount as dividend. As such, dividend payout depends a lot on the cash (after meeting its capital expenditure and working capital requirements) a company generates during a year.

It quite often happens that many companies will not need to reinvest much into the business (in spite of having high return on investments), purely because they don't see the need for it. A classic example would be of companies from the FMCG sector. The FMCG sector is a slow yet steady growing industry. Most of the companies garner high return on their investments in this sector. But yet they choose to pay out huge dividends due to the sector's slow growing nature as capex requirements are on the lower side.

Now if we compare this to say a fast growing industry such as telecom, the situation is quite different. We shall explain this with the help of an example. Telecom major, Bharti Airtel recently announced its maiden dividend of Rs 2 per share. It may be noted that this was after being listed for seven years. The reason for not paying dividends all these years, as attributed by its management, was the huge capital expenditure programme to spread its wings across the entire country.

So, what has made the company announce a dividend this time around? Crossing the peak capex requirement, the management has indicated.

Do all dividend paying companies make a good investment?
The answer is understandably no. This is where the aspect of 'dividend yield' comes into picture. Dividend yield is calculated by dividing the amount paid out as dividend within a year by the company's share price. An example will help in understanding this better.

Assuming a company's stock is trading at a price of Rs 100 and during FY09 it has paid a dividend of Rs 5 per share in total. This stock would be having a dividend yield of 5% at the current price. Assuming that the company is growing steadily and is expected to pay dividends in the coming year, the investor could have surety of earning at least a 5% return on his investment.

However, it may be noted that you should not purely go out and buy a stock which has a high dividend yield. It is very important for you to study the company before deciding to purchase a high dividend yield stock. It could be possible that a company may not be in a position to pay dividends or it might pay lower dividend in the future (as compared to earlier years) due to various reasons an unprecedented loss, higher capex requirements, diversification into newer areas, amongst others.

Investing: Back to Basics Article Series - Previous article | Investing: Back to Basics Article Series | Next article

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